The Fuss Over Fiduciary
I wrote an article back in November, 2009 titled “The F word you need to know” that discussed why a fiduciary standard was being hotly contested among policy makers and lobbyist as part of the Wall Street Reform Bill. A fiduciary is someone who puts your financial interest ahead of his or her own. Fast forward 8 months and we have The Wall Street Reform and Consumer Protection Act of 2010 that passed on July 15th, 2010. So what was passed that you need to know? If you guessed a mixture of nitrogen, hydrogen, carbon dioxide and methane, you are close. (http://en.wikipedia.org/wiki/Flatulence) Your interest and “protection” were essentially punted to a study.
In the 11th hour, Senator Tim Johnson of South Dakota inserted an amendment into the bill that removed a key cornerstone of consumer protection: The fiduciary standard. This amendment cut out a part of the original bill that would have required everybody who gives investment advice to the public to act as a fiduciary. Instead, Johnson effectively stalled the issue by writing language in the Act that requires that the SEC conduct a 6 month “study” on the effectiveness of existing standards of care for broker/dealers and investment advisors. I believe that the study is simply window dressing to give the appearance of performing due diligence on the issue. To wit, the SEC already has a 2008 Rand study that supports the fiduciary standard, and sausage language saying that the SEC is empowered but not required to impose a fiduciary standard.
Aside from the study, the Act states that brokers don’t have a continuing duty to their clients–which might mean that the broker can offer a financial plan as a fiduciary and then sell the heck out of the client after the presentation: “The sale of only proprietary or other limited range of products by a broker or dealer shall not, in and of itself, be considered a violation of the [’40 Act RIA] standard.”
The key issue
Registered Investment Advisors (RIA) and “Fee-Only” advisors believe that something called a “fiduciary standard” is the very best framework for professionals to work with clients. To act as a fiduciary means we professionals have to put aside our own financial interests, and also put aside the business/financial interests of any company we work for, and give recommendations that are solely and completely in the best interests of people like you, our clients. Most financial advisors are not held to this high standard. Rather, they’re held to a “suitability” standard, meaning they’re supposed to reasonably believe that the investment and insurance products they want you to buy are appropriate for your situation. Appropriate is a long way from “in your best interests”.
Broker-dealers and insurance companies disagree with a fiduciary standard. They argue that their salespeople already have to adhere to rigorous regulations and that applying a fiduciary standard to them might prohibit them from charging commissions or limit the products that they can sell. As one broker/dealer spokesperson said ”The group now has ’concerns about imposing the fiduciary duty and its unintended consequences on small investors.’” What is the unintended consequence about putting your clients’ interest first? Simply put, lucrative commissions disappear.
Bob Veres, renowned financial columnist and editor of Inside Information, a newsletter for financial planners, offers some valuable insight about this debate. “Look at the motives of those who are in favor of a fiduciary standard, and at the motives of those who oppose it. Those in favor–generally the most informed consumers and members of the RIA community–have very little to gain, personally and professionally–from their advocacy. The astute consumer will find the fiduciary needle in a haystack regardless of the regulatory structure. RIAs are actually advocating for more meaningful standards imposed on professionals like them. The brokerage firms, meanwhile, are protecting extremely lucrative sources of revenues, including profit margins dramatically higher than most American businesses. I would argue that the SEC should give their arguments less weight in the fiduciary debate; not only are they predictable and self-serving, they are also visibly not in the interests of the retail financial customer.”
In the Wall Street Journal column titled “Brokers Win, Investors Lose Key Reform”, Jason Zweig writes “Securities salespeople generally aren’t obligated to act in your best interest. They needn’t tell you that they make extra money pushing one particular investment or that cheaper alternatives might provide you a higher return. Suppose two mutual funds are “suitable,” but one of them pays the broker a fatter fee. You may well end up in that one—without finding out that your broker had an incentive to favor it.”
What can you do?
Don’t wait for the SEC to conclude its study. Come January, I don’t think we will be any further along in “protecting” your interest. Rather, ask these questions that matter:
- Are you a fiduciary, and if so, do you have a fiduciary oath or pledge that you will sign?
- Will you provide written disclosure prior to our engagement, and thereafter throughout the term of the engagement, of any conflicts of interest, which may compromise your impartiality or independence?
- Do you receive any compensation or other remuneration that is contingent on any purchase or sale of a financial product?
- Do you receive a referral fee or other compensation from another party based on a referral of a client or a client’s business?
There is a world of difference between a fiduciary selling investment advice and a broker selling investment products. Advisors are only as good as the advice they give. Fiduciaries stay in business by helping their clients reach their investment goals. Brokers, on the other hand, stay in business selling stocks, bonds, or funds and pocketing commissions. When it’s your hard earned money, which relationship sounds better to you?
Know Your Deductions at Tax Time
Of all the things I would like to write about, like the impending downgrade of U.S Treasuries, bond investing or IRA rollovers, Michelle Kim asked me to write an article about tips for filing your taxes. Michelle, I would rather count fire ants in my yard but here goes one for your insomnia.
Since I’m not a Certified Public Account (CPA) and I don’t play one on T.V., I asked my long time friend and CPA Lorain Arnold to give me list of possible deductions. As Lorain points out, the list is only meant to give you ideas, or steer you in the right direction. They are not all-inclusive and not all items are deductible all the time. Many are subject to limitations, may only apply in certain situations or are governed by other rules. Please keep careful records and save your receipts for 3 years in case of audit.
Business Expenses
Employees: Includes expenses for your job for which you weren’t reimbursed, but you only get the amount in excess of 2% of your AGI (adjusted gross income), and only if you can itemize. For instance, if your AGI is $100,000, you must have at least $2000 in employee business expenses before you will begin to benefit from the deduction.
Self-Employed: You are allowed to deduct most business expenses in full.
Advertising and Promotion Expenses (Self-employed)
Books and Publications
- Books, trade journals, newspapers and publications for your trade or profession
Dues and Fees
- Dues to a professional organization for people in your profession
- Union dues, initiation fees, and assessments for benefit payments to unemployed union members.
- Regulatory fees for your profession
- Dues to chambers of commerce and similar organizations if the membership helps you carry out your job duties (see exceptions).
- Licenses paid to state or local governments
Education and Research
- Educational expenses related to your present work that maintains or improves your skills.
- Research expenses
Equipment and Supplies
- Business use of computer. Employees: Must be for the convenience of your employer and required as a condition of your employment.
- Supplies and tools you use in your work
Home Office
- Expenses for an office in your home IF part of the home is used regularly and exclusively for your work. Employees: the use of your home office must also be for the convenience of your employer.
- For more information, see IRS Publication 587
Internet
- Employees: Must be for the convenience of your employer and required as a condition of your employment.
Job hunting expenses (Employees)
- To deduct job hunting expenses, you must be looking for a job in your present line of work (i.e., you’re not changing professions or looking for your first job). Expenses include:
- Resume preparation (drafting, typing, printing, mailing, faxing)
- Employment agency fees
- Executive recruiters’ fees
- Portfolio preparation costs
- Career counseling to assist you in improving your position
- Legal and accounting fees you pay in connection with employment contract negotiations and preparation
- Advertising
- Transportation costs to job interviews
- Long distance calls to prospective employers
- Newspapers you purchase to read the employment ads
- Other business publications you purchase to read the employment ads
- Half of your meals you pay for that are directly related to your job search
- If you take a trip away from home to look for a new job, your expenses for traveling, lodging, meals (50% of the cost), etc. are deductible only if the primary purpose of your trip is to look for a job. To substantiate the purpose of your trip, keep a daily log of your interviews, application efforts, etc.
Meals and Entertainment
- Meals and Entertaining costs (only 50% of the cost is deductible). Keep a record of the date, place, amount of expenses, people present, business purpose, and business discussed. Also keep receipts for expenses in excess of $75.
- For more information, see IRS Publication 463
Telephone Charges
- Business use of cellular phone
- Cost of long-distance business calls charged to home phone
- Separate business telephone (home phone line is not deductible)
Travel and Transportation
- Traveling costs incurred while away from home on business
- Traveling costs paid in connection with a temporary work assignment
- Transportation between your home and a temporary work location if you have no regular place of work but you ordinarily work in the metropolitan area where you live and the temporary work location is outside that area
- Transportation between your home and a temporary work location if you have at least one regular workplace for this employment. It doesn’t matter how far away the temporary location is in this case.
- Transportation from one job to another if you work two places in one day
- If you are self-employed and your home is your principal place of business, all business travel is deductible.
- For more information, see IRS Publication 463
Uniforms and Gear
- Protective clothing and gear
- Uniforms (except if you’re full-time active duty in the armed forces)
- Dry cleaning costs for your uniforms or protective clothing (not for your everyday clothing, though)
- Specialized clothing designed for your job, as long as it’s not suitable for everyday wear
- Safety equipment, such as hard hats, safety glasses, safety boots, and gloves
Miscellaneous
- Gifts, but only up to $25 per recipient
- Passport for business travel
- Postage
- Office supplies
- Printing and copying
- Legal and professional services (tax preparation fee)
- Medical exams required by your employer
- Occupational taxes if they’re charged at a flat rate by your city or other local government for the privilege of working in that area
- Business liability insurance premiums
- Job dismissal insurance premiums
- Damages you pay to a former employer for a breach of employment contract
- Employee contributions to state disability funds
Self-Employed Only
- Interest on business loans
- Self-Employed health insurance (partial)
- Commissions and fees
- Business insurance
- Keogh or SEP contributions
- Rental of business property
- Office rent and utilities
- Repairs and maintenance
- Business taxes and licenses
Andrew Brown is a Certified Financial PlannerTM and a Fee-Only Registered Investment Advisor. Lorain J. Arnold Jr. is a Certified Public Accountant with Arnold Gallivan Levesque P.C.
Life Planning Resolutions
I’ve put together a list of resolutions for you to consider for the new year. The term “Life Planning” encompasses the human side of financial planning by discovering the client’s most valued goals and setting in place the blue print for them to pursue their aspirations, overcome obstacles and create a foundational financial plan. Still a little foggy from Santa duties, I will attempt to give you both broad, subjective goals to consider as well as some specific financial planning issues to examine for 2010.
In order to discover what’s important in a client’s life, I will ask some rather unusual questions, a process called appreciative inquiry. For example, if your doctor called you and said “Your test results are in, and unfortunately, you only have 3 years to live”, what would you do differently with your life? This helps me discover the client’s deepest and most profound goals. Next, what if the doctor called again and said “I made a mistake, you only have 3 months”. Would your actions change? Along the same line, if you died tomorrow, what is your biggest regret? Once these questions are answered, you can them start the process of setting goals. Many times, the answers to these questions involve something you currently are not doing. Now ask yourself why? Make it a goal for the new year.
The next step is a rather difficult exercise. Write down 30 personal goals in your life. The first ten will be easy, the next ten get harder, and the last ten goals you have to really dig deep. It’s in those last ten goals that I discover some top 10 goals, you will as well. My charge as a life planner is to keep my client updated on achieving those goals and coach them on getting there. At the risk of seeming too esoteric, I will stop here with the life planning talk and move to some specific financial planning items.
Make Sure You Understand Who Works For Whom
If you are in the market for an investment product, be sure to find out who the salesman works for before consummating any financial agreement. It’s hard to be a financial consumer these days, especially when it comes to knowing who you can trust. Millions of investors hire salespeople to give them investment advice–which is a little bit like hiring a used-car salesman to give you advice on which car to buy and how much to pay.
While most salespeople are pretty easy to spot, mercantile hacks can be shrewdly subtle. For instance, instead of referring to themselves as a broker or securities salesman, some representatives of Wall Street firms (the companies that recently took our global economy to the brink of collapse) have adopted more regal titles, like “vice president of investments” and/or “financial advisor.” Many now claim to charge fees for their services like a genuine independent fiduciary when in truth their position is nothing more than a glorified broker pulling in a paycheck from a firm. All along the rep recommends products that are highly-profitable to his employer–which goes a long way to explain those billion-dollar employee bonus pools that you’ve probably read about. Cut to the chase: Ask any financial representative for his fiduciary credentials. If he is not willing to put your interest ahead of his own, perhaps that vehicle he’s peddling belongs on a lot next to the rest of the used cars.
Covering The Basics
• Contribute to your 401(k) and if possible, defer the maximum $16,500. If you are over age 50, you have an additional $5,500 catch up provision.
• Consider a Roth Conversion in 2010 when there are significant one-time-only opportunities. In 2010 only, the $100,000 income limits are removed on converting your traditional IRA into a Roth. All Roth conversions require you to pay income tax on the conversion amount: However; Those who do the conversion in 2010 can defer the resulting taxable income for the next two years, 2011 and 2012.
• IF you are age 55 and older, start shopping for long-term care (LTC) insurance. When considering how to plan for LTC, don’t count on Medicare or Medicaid. Medicare doesn’t cover LTC expenses, and Medicaid requires you to go broke before going into a welfare nursing home. Aside from the complications in applying and qualifying for Medicaid, simply visiting a government run nursing home and a private pay nursing home will illustrate why Medicaid is also called “impoverished care”.
• Review your estate planning documents. If your documents are older than 5 years, dust them off, read them and see if changes are needed. In addition to examining your will, both the power of attorney document and advanced directive for healthcare document should be reviewed. The Georgia Advance Directive for Health Care Act was passed in 2007 and your documents should be updated accordingly.
• Make sure your homeowners insurance policy is for REPLACEMENT costs. Ask your insurance agent.
• If you have an interest in investing, join the American Associating of Individual Investors, AAII. Great organization for educating individual investors. (aaii.com)
Every new year brings another chance to begin anew, to wipe away past mistakes and write a fresh chapter of noble purpose and character. Your financial security is the foundation for all your good works, and it deserves your careful reflection. 2010 offers us the privilege to keep those promises we make to ourselves and to those we love—to be better, more generous, more understanding. It is a duty not to be taken lightly. For as the man I most admire used to say, “Nothing is more valuable than your word.”-Grant Brown
The F Word You Need To Know
Last week during two separate new client meetings I was asked the same question: What is a fiduciary? I find the question particularly interesting because it mirrors a very significant debate taking place in Washington. First, the ambiguity of financial advice among the public and regulating bodies, and second, the lobbying from the broker-dealer industry to keep the word out of your vocabulary.
The point of contention centers on the word fiduciary. Fiduciary is derived from the Latin fidere, to trust. Trust is the pillar in an advisory relationship. If a fiduciary standard means “putting a client’s interests above your own,” who would argue about that? If you guessed Wall Street, you are right. Because so much media attention is given to the healthcare debate, most of us don’t know about this David vs. Goliath battle taking place in the House Financial Services Committee.
Missed Regulations, Misconceptions and Misunderstandings
To understand this debate in Washington, we need to first set the stage on why the Obama Administration is proposing the Investor Protection Act of 2009. Thanks to the string of financial frauds and huge losses in the stock market, the public’s trust in the financial system has eroded considerably. The proliferation of titles used by financial professionals has only added confusion. As a result, Congress is taking a long hard look at how financial advice is delivered, how the advice is regulated, and what, if any, standards should apply as part of the Investor Protection Act of 2009.
The financial services laws and regulations were mostly written during the Great Depression for two key areas: Laws governing investment advice, which impose a fiduciary requirement on the adviser to act solely in the best interests of the client; and laws governing the sale of financial products, which imposes a lower suitability standard. The patchwork of dated regulation has left gaps that allow anyone to call themselves a financial planner or advisor without appropriate competency and ethical standards. What about when the delivery of financial services involves a combination of various product sales and financial advice? This gray area allows someone to act as a fiduciary when presenting advice, but become a salesperson when implementing that advice by selling products that could benefit the advisor rather than the client.
Federal and state law requires that Registered Investment Advisors are held to a Fiduciary Standard. This law requires that an advisor act solely in the best interest of the client, even if that interest is in conflict with the advisor’s financial interest. Investment Advisors must disclose any conflict, or potential conflict, to the client prior to and throughout a business engagement. Investment Advisors must adopt a Code of Ethics and fully disclose how they are compensated. Following a fiduciary standard is not the norm, nor is it how you build sky scrapers or stadiums.
The majority of financial advisors are paid by commissions and don’t adhere to a fiduciary standard. These other advisors often work for large financial services firms, known as Broker-Dealers. The loyalty of these advisors is to their employer, not their client because they are required by federal law to act in the best interest of their employer, not in the best interest of their clients.
Main Street Has a Chance
Congressman Michael Capuano, D-Massachusetts, has agreed to put forward the Financial Planning Coalition’s proposed legislation that would be big win for consumers. In its essence, the amendment says that financial planners and advisers—like doctors, lawyers and accountants—should be subject to a professional oversight board, under the authority and oversight of the Securities Exchange Commission, which establishes and enforces baseline competency and ethical standards. This will allow consumers, seeking professional advice, to identify competent and ethical financial planners who are required to proactively disclose all conflicts of interest and act in the client’s best interests first and foremost.
The broker-dealer lobby wants no part of the Capuano Amendment. They prefer to keep the Merrill Lynch exemption that allows stockbrokers to offer the same services as Fee-Only financial planners without being accountable to the same fiduciary standards. If it looks like a fiduciary standard will prevail, their effort will focus on a crafty invention called “harmonization”, which is a watered down definition of fiduciary currently demanded of Registered Investment Advisors.
One Question Feared Most by Many Financial Professionals
The most important question you can ask of anyone offering you financial advice is, “Do you have a legal fiduciary obligation to act in my best interests?” This draws the line in the sand that separates those who sit on your side of the table and have a legal obligation to act in your best interests and those who sit on the other side of the table and have no such obligation. The Merrill Lynch rule requires that your stockbroker disclose in writing: “Your account is a brokerage account and not an advisory account.” And “Our interests may not always be the same as yours.”
If this disclaimer appears in agreements you are signing, ask your advisor how he or she is compensated and where their loyalties lie. Then decide if the relationship is in your best interest. Don’t be afraid to use the “F” word. It’s a nine letter word that could spell the difference between your comfortable retirement… or your advisor’s.
Long-Term Who Cares
As households are trying to reduce debt and increase savings, taking on additional expenses in the form of insurance premiums seems counterintuitive, especially when many people perceive the insurance as non essential. Instead of writing a “long-term care 101” article that could cure insomnia, I’ve focused on why you may need it, and how to save money if you decide to purchase a policy.
If you’ve attended a long-term care (LTC) seminar, or read literature from insurance companies, then you know how dire they make the statistics look. In fact, the estimates and projected probabilities for care look so abysmal, you might dismiss it all together as insurance propaganda. Unfortunately, independent sources only confirm their accuracy. According to the American Association of Retired Persons (AARP) in a report titled “Beyond 50.2003: A Report to the Nation on Independent Living and Disability” the lifetime probability of becoming disabled in at least two activities of daily living or of being cognitively impaired is 68% for people age 65 and older. An exhaustive list of studies and statistics from universities, associations and think tank organizations all support favorable odds of a long-term care event occurring.
When considering how to plan for LTC, don’t count on Medicare or Medicaid. Medicare doesn’t cover LTC expenses, and Medicaid requires you to go broke before going into a welfare nursing home. Aside from the complications in applying and qualifying for Medicaid, simply visiting a government run nursing home and a private pay nursing home will illustrate why Medicaid is also called “impoverished care”.
The costs of self insuring for LTC Home health services run $29 an hour, which adds up to $36,000 a year for assisted living and $56,000 a year for a nursing home (Health Care Financing Administration, Office of the Actuary, National Health Statistics Group). Moreover, nursing home costs are expected to quadruple by 2030. Consider this example: A 60-year-old client who wants long-term care insurance that would pay $120 of daily expenses for five years of assisted living would face a premium of $2,000 per year. For the 40 year old client, paying on the policy for 20 years is still less costly than one year of care.
Complexity and Confusion of Policies Work Can Against You
Today’s LTC policies are complex and can overwhelm you with the different features. According to the Kaiser Commission, policies with the same design elements can differ from one insurance carrier to another in even more subtle ways such as the definition of certain services. For example, some policies may state two out of five activities of daily living (ADL) instead of two out of six. What’s the difference?
With a good policy, LTC benefits start when you can’t perform two of six activities of daily living (ADLs): eating, bathing, dressing, toileting, continence, and transferring (getting in and out of a bed or chair). The most common activity lost first is bathing. Some insurance companies will list only five ADLs and leave out bathing, a major red flag.
Another area of confusion involves cognitive impairment. A good policy covers the likelihood of Alzheimer’s, senility, irreversible dementia, and mental dysfunction caused by a stroke. Stay away from a policy that doesn’t have these cognitive impairments listed. Furthermore, coverage for cognitive impairment should not be tied to your ability to perform the activities of daily living, as some inadvisable policies state “you have coverage if you can’t do two out of six activities of daily living AND are cognitively impaired.” You may very well loose your cognitive ability and still perform these ADLs but need supervision. AND is a red flag.
Must Have Features
You should also scrutinize the scope of benefits to make sure you have coverage on things such as home care, adult day care, and assisted living. Again, the contract language is important because you will want a policy that pays for all levels of doctor ordered care, in any state licensed facility, including nursing home, assisted living or adult foster care. Put a red flag on policies that restrict you to selected nursing homes. Those facilities are often not the level of care you would want.
Scott Foster, CLU, a State Farm agent in Conyers offers helpful advice about some “must have” features when shopping for a policy. “If you’re under the age of 65, you must have inflation protection in your policy. Over the age of 65, maybe or maybe not. Also, make sure the per day pay amount is adequate for where you want the care. The cost of care in Boston is three times more expensive than the cost of care in Atlanta.” Foster adds that “Another must have is the ability to use your own doctor. Reputable companies allow you to use your own doctor. To do otherwise, is a conflict of interest.”
How Long, When and Where to Buy
You can trim the policy costs by changing the duration of the policy and elimination period of the policy. Consider shortening a policy’s benefit period to three years. A Milliman actuarial study estimates that only 8 percent of 70-year old claimants will have a claim going beyond five years. Second, an elimination period of 60 or 90 days will probably coordinate with the termination of Medicare benefits. The big question often asked is when to buy a LTC policy. I recommend you start shopping for a policy after the age of 55. After the age of 60, the premiums jump considerably.
Only buy LTC insurance from a company with an A.M. Best Rating of A++ or A+. Clarkhoward.com has a link on his website that takes you to his list of recommended LTC insurance companies. Financial strength is crucial, especially in light of last year’s financial meltdown when companies like Genworth Financial went from $20 a share to a dollar and change. Aside from the strength of the insurance company, I advise clients to look at the expertise and knowledge of the individual selling you the policy. I recommend buying from someone who is a full time insurance agent with a strong background in LTC, rather than buying from someone who sells LTC insurance as an incidental add on to his or her main profession.
We use insurance to transfer the risk of an event away from draining our savings on to the resources of an insurance company. We pay for this transference of risk for different perils like fire, death, collision and health. Why not long-term care?
Andrew Brown is a Certified Financial PlannerTM and a Fee-Only Registered Investment Advisor.
Economic Picture Looks Like My Own
Instead of readers commenting on my last two columns, they have commented on my picture. My own wife says that I bear a strong resemblance to our dog, Mack. I was encouraged to change it…Good Grief! Much like the economy, we can look at this from two points of view: Either Mack is a rather gruff looking person (inflation), or I’m a handsome dog (deflation).
As we look at the recent monetary, fiscal and legislative policies designed to address the “economic crisis”, the popular conclusion points to hyper inflation. After all, massive increases in the Fed’s balance sheet is inflationary, right? Add to this the historical surge in federal government spending and almost incomprehensible deficits intended to stimulate economic activity, and the arguments in favor of inflation appear to make sense…on the surface.
While I would rather face inflation, we face some serious issues that may steer us into deflation. In the past year, the Fed’s balance sheet, as measured by the monetary base, has nearly doubled from $826 billion in March 2008 to $1.64 trillion, with larger increases on deck. The historical increases in the monetary base have not lead to economic growth or creating new credit. Why? The simple answer is money supply. While M-0 (what comes off the printing presses) is sky rocketing, M-2 (what makes its way into the economy) has barely moved. In short, banks are soaking up every dollar they can to rebuild their balance sheets. Over the past year, while total reserves increased by $736 billion, only 1.9% was available for loans. Hence, for the first quarter of 2009, bank loans fell 5.4%.
While most recessions come from excess manufacturing inventory, this one is the result of excess credit. Economic activity cannot move forward unless credit expansion follows reserves expansion. Because this isn’t happening, we have may have witnessed the end of a 70 year credit expansion cycle that started after World War II. Over a 25 year period, we’ve gone from societal debt of 150% of Gross Domestic Product (GDP) to 350% of GDP. As only policy makers can do, they will make matters worse by increasing regulation on the very banks that are already reluctant to lend money.
Another factor to consider in the inflation vs. deflation debate is U.S. Government Debt, predicted to be 72% of GDP in 4 years. History shows us that massive increases in government debt weaken the private sector and slow an economic recovery. Some economists argue that by weakening the private economy, government borrowing is not an inflationary threat. In looking at Japan from 1988 to 2008, their government debt to GDP ratio grew from 50% to 170%. Did government spending lead to prosperity? No, Japan is in the midst of its worst recession since the end of World War II, with declining GDP much worse than ours. Incidentally, Japan’s increase in debt was a result of bailouts for banks, insurance companies, manufacturers and FDR style works projects. If government spends $1, it must raise $1 in taxes. The $1 raised in taxes comes from individuals and business who would otherwise have put the money to use in the private sector, purchasing goods, services or taking risks thru business investment or expansion.
So where does all this lead us for making portfolio decisions? For the short term, deflation is still a significant threat. Looking down the road, 3 to 5 years, I hope we do have inflation because if we don’t, our problems will have gotten worse. Trying to outsmart the economy by making big short term bets on inflation with your portfolio may prove disappointing. A good way to hedge your bet would be buying U.S. Treasury Inflation-Protected Securities (TIPS). You can do this online at treasurydirect.gov. I prefer using the iShares Barclays TIPS Bond, symbol TIP. You’ll have the liquidity of a stock, no phantom income tax concerns and a current yield around 4.8%.
Whether all the new dollars continue to sit in banks or make it out into the broader economy, inflation will eventually take a bite out of every investor. Our best hope is for government to limit spending and regulation so that exploding productivity can muzzle the monster before it gets out of control.
Does Your 401k Have Termites
Market turmoil and economic uncertainty have caused most of us to pay more attention to our 401k plans. Invariably, whether talking with parents at my daughter’s soccer game or sharing coffee at church, I’m asked the same question: “Will you look at my 401k?” What they want is help selecting among the 10, 20 or 30 funds offered in their plan and hoping to find the magic combination that will provide superior returns. And here lies the problem: If you have a 401k plan based on a closed architecture platform, you have termites eating away your returns. The termites are the hidden fees.
Most plan participants are completely unaware of these fees. Based on a 2007 study by the American Association of Retired Persons (AARP), only 17% of plan participants knew what fees they were paying inside their 401k plan. But, high fees can consume profits at an alarming rate. The congressional Committee on Education and Labor found that paying just 2.4% in higher administration fees can cost a plan one-third of its potential earnings when annual contributions are compounded over 30 years. This study was done to examine proposed legislation on Fee Transparency. Simply put, high expenses are like termites eating away at your investment returns.
So, where are the termites? The fees inside a 401k plan go to management fees, record-keeping, “shelf Space” fees, trading costs, and commissions paid to sales people who sell the plan (sometimes referred to as 12b-1 fees).
The best pest control is a plan with an open architecture in which all fees are listed up front and there are no hidden costs. Unfortunately, the majority of 401k plans offered are based on a closed architecture platform with hidden fees and limited—often mediocre—mutual fund choices. There are two ways you can easily determine if you have a closed platform: First, nearly all plans offered through an insurance company or a mutual fund family are closed architecture; Second, plans with a mutual funds containing B,C, T or R share classes are also closed. These shares are particularly worrisome because they always underperform their no-load or A-share class counterparts.
By all means, please don’t read this article and bang your boss’ door down. More than likely, your employer isn’t aware of the hidden costs in a closed architecture platform either. Most companies are unaware of the expenses incurred in their plan because the fees are hard to find. You have to carefully read the Summary Plan Description and each Fund Prospectus to find the fees.
In contrast, open architecture plans have complete fee transparency with no sales charges or trailing commissions. Any 12b-1 fees reimbursements go back to the participants. In addition, the plans typically have access to no load funds, index funds and no-fee institutional share mutual funds. These plans offer a wider range of investment options and have lower investment management and plan administration fees. Moreover, open plans use an independent investment advisor to satisfy ERISA due diligence requirements, which is a critical safety feature for the investor.
Don’t throw away the earnings on your investments. Work with an open architect advisor and keep those termites where they belong—far away from your money.
For employers, there are 3 key questions you should ask about your plan:
- Is your plan advisor a fiduciary and completely fee-only?
- Does your plan provider participate in the industry’s standard practice of revenue sharing?
- Are there 12b-1, sub T/A or finders fees being paid? If so, to whom and for what services.